What tariffs could mean for small-cap stocks

The latest round of US tariffs – and the retaliatory moves from other countries – is throwing businesses worldwide into a messy, high-risk trade game. But where there are risks, there are often opportunities. And in this case, those could swing in favor of US small-cap companies.

So why small caps?

At the heart of the US tariff barrage is an attempt to protect American industries and shrink the country’s trade deficit. That means disrupting supply chains, making imports pricier, and creating headaches for businesses that rely on foreign materials. The idea is to supercharge homegrown goods, for lack of a better term, supercharging domestic production and giving smaller US-based firms a shot at replacing those lost imports.

Mind you, not all small firms will benefit, but those with strong business models, pricing power, and sturdy balance sheets could be in prime position to ride out the coming turmoil – and maybe even come out on top. Here are a few reasons why you might want small-cap stocks on your radar (and in your portfolio) right now.

Reshoring and supply chain reconsiderations.

One of the primary ways tariffs could benefit small-cap companies is through the reshoring (or bringing home) of manufacturing work. As tariffs make foreign goods more expensive, many US firms will adapt their supply chain strategies to increase domestic sourcing and production. This shift will naturally present new opportunities for smaller companies across sectors.

For instance, reshoring projects will drive demand for local construction crews, concrete suppliers, and equipment rental companies. And regional banks will play a key role in financing these initiatives – those kinds of customers are their bread and butter. Meanwhile, new semiconductor facilities will require highly specialized “HVAC”, or heating and cooling, systems with nearby maintenance and repair services. That could throw the door wide open for small-cap companies to walk in and position themselves at the center of these expanding domestic supply chains, benefiting from stronger revenue and earnings growth.

Tariff-driven innovation and efficiency.

Tariffs have also spurred innovation and efficiency improvements among small-cap companies. Many businesses are investing in automation, advanced manufacturing techniques, and other things to offset rising material costs and enhance productivity. These efforts can help maintain margins and better position small-cap firms for long-term success. This is especially relevant for technology and industrial companies that lean on innovation to reduce dependence on foreign inputs and strengthen their competitive position.

The competitive landscape.

Counter-tariffs imposed by other nations in response to the new US policies could also play a role in shaping the competitive landscape. Countries like China have targeted US exports, impacting industries such as agriculture and automotive. While some small-cap exporters face new challenges, others have successfully pivoted to alternative markets. And, naturally, companies that can adapt to shifting trade dynamics and diversify their customer base will be best positioned to thrive.

The economic environment.

The broader economic backdrop should be positive for high-quality small-cap stocks. After all, the US economy is expected to continue to grow – just at a slower pace. And, plenty of companies (especially these smaller fries) have already strengthened operations in response to past disruptions, like the pandemic supply chain snarls and trade volatility from this president’s first term. These efforts are likely to pay off in the current turmoil.

Earnings growth.

Right now, small-cap stocks are gaining attention for several reasons. Investors have been looking to diversify lately, given the outsized concentration of “Big Tech” names in the major US stock indexes. That shift is timely, as small-cap companies are expected to deliver stronger earnings growth relative to their large-cap counterparts (Chart 1). This is an important development as small-cap growth rates have lagged large-caps for several years.

The profit growth of the stocks in the Russell 2000 index (RTY) vs. those in the S&P 500 (SPX). Sources: FactSet, Bloomberg, Aberdeen.

Attractive valuations.

Furthermore, small-cap stocks are trading at attractive valuations, with their discount to large-caps near historic lows.

Small-cap stocks’ valuations, as measured by their forward price-to-earnings ratios, relative to those of their big-cap peers. Sources: FactSet, Bloomberg, Aberdeen.

While multiple factors have contributed to this valuation gap, earnings growth differentials have been key drivers. As small-cap earnings accelerate, this discount should begin to narrow, presenting a compelling opportunity for investors.

What’s the big takeaway then?

The latest tit-for-tat tariffs US tariffs and the retaliatory measures from affected nations are reshaping the competitive landscape for US small-cap companies. While there are definitely risks, there’s also a silver lining – a bigger push for domestic manufacturing, supply chain diversification, and innovation could actually fuel long-term growth for a lot of firms. With the economy still holding steady and small-cap stocks looking historically undervalued, this could be a prime moment for investors who are looking to cash in on shifting trade dynamics. In all this chaos, high-quality small caps just might be the market’s hidden gems.

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